Driven by equity markets, DB plans recover in Q2. But can it last?

July?2, 2020

Canada, Toronto

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The Mercer Pension Health Index, which represents the solvency ratio of a hypothetical defined benefit (DB) pension plan, increased from 93?per?cent at the end of March to 101?per?cent at the end of June. The median solvency ratio of the pension plans of Mercer clients was at 91?per?cent on June?30th, up from 84?per?cent on?March?31st.

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During the second quarter, funded positions of DB plans recovered slightly less than half the losses they incurred in the first quarter. The improvement was fueled by double-digit second quarter returns across all equity markets, but restrained by declines in long bond yields which boosted liabilities.

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“While the last few months have been painful, most defined benefit plans have emerged from the depths of the crisis in reasonably strong shape,” said Manuel?Monteiro, Partner and Leader of Mercer Canada’s Financial Strategy Group. Measured across the backdrop of the 20+?years since January?1,?2000, funded positions have been higher than they are today, less than 30% of?the?time.

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Businesses that are struggling with the economic effects of the pandemic will be thankful that they will generally not face near-term increases in DB?pension contributions. Many plan sponsors will be filing year-end 2019 valuations, which will allow them to defer any funding increases until 2023. Further, the lowering or elimination of solvency funding in provinces such as Ontario, Quebec and British Columbia will dampen the size of contribution increases that do occur if funded positions do not recover over the next few?years.

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While economic activity continues to be deeply affected by the pandemic, equity markets are now only down slightly since the beginning of the year, and seemingly pricing in a “v-shaped” recovery. Conversely, long-term bond yields continue to test new lows suggesting a future of low economic growth and tepid inflation.

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“The risks for DB?plans loom large,” said Monteiro. “Equity markets have gotten ahead of the real economy, and seem highly vulnerable to any disappointing news regarding the strength of economic recovery, the stubborn persistence of the virus, or the development of an effective?vaccine.”

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Closed and frozen plans that remain well funded should strongly consider taking risk off the table, through increased allocations to defensive assets, diversification away from equities, annuity transactions, or even merging into jointly-sponsored pension plans that have opened their doors to private sector?employers.

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Plans with long time horizons have a difficult road ahead of them. Given the paltry yields on bonds, they have to remain significantly invested in growth assets in order to remain affordable. However, large allocations to growth assets will make them more susceptible to market volatility. The challenge will be to strike a balance that best meets the objectives of the employers and plan members. Realistic contribution rates, risk-sharing design features, broad diversification across asset classes, and selecting the right investment managers will become even more important going?forward.

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From an investment standpoint

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A typical balanced pension portfolio would have posted an exceptionally strong return of 13.0 per?cent during the second quarter of 2020 as equity markets rebounded and bond yields?fell.

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The Canadian equity market outperformed all developed markets in Canadian dollar terms in the second quarter. The S&P/TSX Composite Index returned 17.0 per?cent. Ten out of eleven sectors posted positive returns with Information Technology leading the?way.

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Fueled by declining yields, long-term bonds generated a double-digit quarterly return. Real return bonds and universe bonds also had strong returns (6.2?per?cent and 5.9?per?cent, respectively).

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Global equity markets also rebounded significantly, however the appreciation of the Canadian dollar detracted value for unhedged Canadian investors. The U.S. equity market led the way, returning 20.5 per?cent in USD terms (15.3 per?cent CAD), while international equities were also accretive for investors returning 12.8?per?cent in local currency terms (10.1?per?cent CAD). Some of the more volatile equity market segments, namely small cap stocks and emerging markets partially recovered from deep losses in the first?quarter.

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“Despite a strong rebound in risk assets as the recovery has continued throughout the second quarter, we remain cautious regarding the long term impact of the pandemic on the economy and markets going forward” said Todd Nelson, Partner at Mercer Canada. “Markets have been encouraged by government stimulus efforts, the gradual relaxation of lockdowns and progress on a number of potential vaccines. However, the recent spikes in case numbers in the U.S. and other countries is increasing fears of a second wave of the coronavirus?pandemic”.

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Both the U.S. Federal Reserve and Bank of Canada held their target rates at 0.25?per?cent throughout the second quarter, following several individual rate cuts throughout the first?quarter of the?year.

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The Mercer Pension Health Index


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The Mercer Pension Health Index shows the ratio of assets to liabilities for a model pension plan. The ratio has been arbitrarily set to 100% at the beginning of the period. The new Pension Health Index assumes contributions equal to current service cost plus solvency deficit payments, and no plan improvements. The Mercer Pension Health Index assumes that valuations are filed annually on a calendar year basis and that the deficit revealed in each valuation is funded on a monthly basis over the subsequent five?years.

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Assets: Passive portfolio. Asset mix for periods up to December?31, 2016 of: 42.5% FTSE/TMX Universe Bond Total Return Index; 25% S&P/TSX Composite; 15% S&P 500?(CAD); 15% MSCI EAFE?(CAD); 2.5% FTSE/TMX 91 day T-Bills. Asset mix for periods on or after January?1, 2017 of 42.5% FTSE/TMX Long Bond Total Return Index; 15% S&P/TSX Composite; 40% MSCI World (CAD); 2.5% FTSE/TMX 91?day?T-Bills.

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Liabilities: 50% active members, 50% retired members. 60% of benefits for active members assumed to be settled through commuted values based on the Canadian Institute of Actuaries transfer value standards without the one-month lag, and the remaining 40% assumed to be settled through an annuity purchase. Benefits for retired members assumed to be settled through an annuity purchase. Annuity prices determined based on the CIA guidance for the medium duration illustrative block. Results will vary by pension?plan.

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The median solvency ratio of the pension plans of Mercer clients is based on a projection of data within Mercer’s client database. The data and projection methodology were refreshed retroactively at September?30,?2019. The approximate impact of the change in data and methodology was a reduction in median solvency ratio of approximately?2%.

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ABOUT MERCER
Mercer builds brighter futures by redefining the world of work, reshaping retirement and investment outcomes, and unlocking real health and well-being. Mercer’s more than 25,000?employees are based in 44?countries and the firm operates in over 130?countries. Mercer is a business of Marsh & McLennan Companies?(NYSE:?MMC), the world’s leading professional services firm in the areas of risk, strategy and people?with 76,000?colleagues and annualized revenue approaching $17?billion. Through its market-leading businesses including?Marsh,?Guy Carpenter?and?Oliver Wyman, Marsh & McLennan helps clients navigate an increasingly dynamic and complex environment.?For more information, visit?www.pinkerton-europe.com. Follow Mercer on Twitter?@MercerCanada.

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